Structuring Employment Severance Agreements

On April 10, 2007, the IRS issued final regulations interpreting the deferred compensation rules under Section 409A of the Internal Revenue Code. The regulations apply to any “nonqualified deferred compensation plan,” which the Code defines as any plan providing for the deferral of compensation, including employment severance agreements. The final rules provide greater flexibility to both employers and employees in structuring severance plans. However, in order to maximize advantages and avoid costly penalties, it is imperative that severance plans comply in form and in operation with the particular requirements of Section 409A.

Section 409A, which Congress added to the Code in 2004, provides that all amounts deferred under a nonqualified deferred compensation plan are currently includable in gross income, unless the plan satisfies the requirements of one of the section’s exceptions. If a plan does not qualify under an exception, an employee is required to include all deferred amounts in his or her current-year gross income. Failure to do so will result in the assessment of a 20% tax, plus interest, on the resulting underpayment, in addition to regular income and employment taxes. Fortunately, the exceptions allow most employees to avoid the consequences of Section 409A, providing that strict timing and documentation requirements are met.

For severance agreements resulting from an involuntary (unilateral) termination, severance pay will be excluded from Section 409A if the amount: (1) does not exceed two times the lesser of (a) the employee’s annual compensation for the preceding year, or (b) the tax-qualified plan compensation limit ($450,000 for 2007); and (2) is paid no later than December 31 of the second calendar year following the year of termination. Significantly, the “two times exception” applies for amounts up to the cap even if the total amount exceeds the cap. Thus, if the total payments to an involuntarily terminated employee exceed the cap, the severance plan can be structured so that the amount up to the cap qualifies for the “two times exception,” and is therefore exempt from Section 409A. The excess amount, however, must comply with Section 409A.

Additionally, severance agreements providing for lump-sum payments immediately following an involuntary termination may also be exempt. The short-term deferral exception operates so that payments rendered by March 15 of the year following the year in which an employee’s severance rights vest are exempt. Under this arrangement, and in contrast to the involuntary termination exception, an employee can receive unlimited amounts of severance pay without facing Section 409A consequences.

Other exceptions contained in the final regulations may be useful to both employers and employees. Among these is a “good reason” termination exception, which treats certain employees who voluntarily leave their employment as if they were involuntarily terminated. Another exception works in conjunction with Section 402(g) to exempt altogether any severance payment not exceeding $15,500.

All in all, the final regulations interpreting Section 409A give employers and employees more options and improved flexibility in structuring severance agreements. However, employers should be aware that all severance agreements must be brought into documentary compliance with Section 409A by January 1, 2008. In the balance of 2007, it is therefore essential that employers reevaluate and revise their severance procedures so that they comply with the requirements of Section 409A.